The Turkey-and-Santa Effect on Stocks

By

Michael Kahn

Updated Nov. 22, 2006 11:59 p.m. ET

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THE END OF THE YEAR is filled with holiday cheer, shoppers in malls and, if history is our guide, higher stock prices. With the traditional holiday season comes the traditional seasonal rally on Wall Street, a fact that while not guaranteed does put the odds on the side of the bulls.

There are many reasons to believe that this seasonal strength will be with us this year just as there are reasons why it won't. Interestingly, one reason for optimism comes directly from the pessimism that is still running wild in the public. This sentiment has gotten so strong that contrarians are getting excited. When everyone is bearish, or at least nervous, theoretically they have already sold and that leaves a dearth of supply. As we know, economics tells us that no supply leads to higher prices.

How do we know people are bearish? Getting Technical covered this sentiment angle last month (see Getting Technical, "Left-Behind Investors Could Aid Rally," Oct. 18) saying that the investors have been using the options market to make big bearish bets. True, the Chicago Board Options Exchange volatility index (ticker: VIX), also known as the "fear index," is very low but it only measures a small slice of the options market.

With the market in a rising trend that just keeps going, sooner or later these bearish bets will have to be unwound. Short positions will have to be bought back. Put options will have to be sold. And all of this represents fuel for the market to keep rising.

From a purely charting point of view, the trends of most of the major indexes are in very good shape (see Chart 1). The speed of the advance seems reasonable. Momentum is not too high or too low. And market breadth -- the number of stocks advancing with the market -- is very healthy.

Chart 1

While it is difficult for most investors to buy stocks that are in strong rising trends and making new highs, this is just the condition for which many analysts look. In the stock market, strength begets strength. Of course, at some point that strength will be used up. But so far, that is not the case.

Chart watchers are now debating whether another market cycle -- the four-year cycle -- bottomed this year ahead of schedule or whether the worst is yet to come. For decades, the stock market has bottomed like clockwork every fourth October (with one significant exception we'll cover later) and that meant an important low was due last month. Analysts, including yours truly, were bracing for a major decline that never materialized.

If we believe that the four-year cycle bottomed slightly ahead of schedule in July, that implies the current rally is part of a new bull leg that can carry on for a year or more.

Now let's move on to the negative technicals. If we believe that the small May to July decline did not set the real four-year cycle bottom, then we are by definition looking for a major low sometime next year.

As mentioned earlier, there was one significant deviation from the four-year cycle, and that was a one-year delay for the expected 1986 cycle low. We all know what happened when the market actually did bottom in 1987, but we are certainly not saying here that 2007 will give us another crash. However, if July 2006 was not the actual cycle low, then we do have an argument to make that the market is not in the throes of a fresh bull market at this time.

Let's recap. The positive technical evidence includes sentiment that remains very overly bearish in terms of options purchases. It includes the very obvious yet significant rising trend that may also be part of a bigger four-year cycle. And it also includes a seasonal tendency for rising prices through January.

The negative evidence so far is limited to the possibility that the four-year cycle has not yet bottomed, and that means a larger decline than the one we saw earlier this year is in the cards.

On the surface, the scales are tipped toward the bulls, but like so many other expected events in the market this year, things seem to be off a bit. The six-month seasonal decline normally starting in May lasted a mere six weeks. The four-year cycle certainly did not fulfill its expectations. And who is to say that the seasonal sweet spot for the market -- from November through January, has not already been used up over the past four months?

To resolve all of this, one very plausible scenario is a few more weeks of rally followed by the long-awaited correction. Fuel provided by all those bearish bets can be used up, and cycle followers can still look for an actual bottom reasonably close to where they expected it. We won't talk about a major decline like 1987 at this time.

Be on the lookout for subtle changes such as heavy volume on days when the market declines. Changes in investor sentiment from bearish to bullish may likely be seen in surveys such as that done by the American Association of Individual Investors. We are already seeing a spate of merger activity that can occur when stocks are high.

But the trend is the trend, and until the market actually starts to fall, who are we to doubt it? The market will tell us when it's ready to reverse.

Getting Technical Mailbag: Send your questions on technical analysis to us at online.editors@barrons.com. We'll cover as many as we can, but please remember that we cannot give investment advice.

Michael Kahn writes the daily "Quick Takes Pro" newsletter (you can get a free trial at www.quicktakespro.com). He is the author of two books on technical analysis, most recently Technical Analysis: Plain and Simple, and was Chief Technical Analyst for BridgeNews. He also is on the Board of Directors of the Market Technicians Association (www.mta.org).

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